By Brendan Conway

Ken Volpert of Vanguard Group’s fixed-income group has a warning for investors who’ve grown enamored of senior loan funds: Be careful.

“Bank loans are basically floating rate high yield invesments,” and they “definitely have some liquidity issues,” Volpert told conference goers at Morningstar ETF Invest in Chicago on Thursday. “The thing to keep aware [of], if there is a recession, don’t think of this floating rate loan portfolio as … ‘It’s going to hover around par with a three or four percent yield.’ You could lose a large percentage of the portfolio.

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“It happened the last time around. [You could lose] 5, 10, 15 percent depending on how bad the credit default picture gets for the high yield markets,” Volpert said.

The Vanguard executive also added a word of explanation why his company doesn’t have a rival to PowerShares Senior Loan Portfolio (BKLN) or the other swiftly rising bank- and senior-loan ETFs: The fear of overcrowding a small and currently very trendy market.

“How big is the outstanding in that market? It could become very big,” if funds keep growing at the current pace — which panel moderator Tim Strauts said was a doubling of investor assets in the last year.

“Are we ultimately creating a tool that could create a lot of flows into too small of a market that leads to a bubble? We are conscious of that. We don’t want to come out with something faddish … The market is small and it could get overcrowded, and ultimately lead to something that creates a problem for investors.”

BlackRock’s Steve Laipply, speaking on the same panel added: “Bank loans are not CUSIP securities. They’re physical loans … In a recession, or if you have a market event or ‘risk off’ event, the liquidity profile of loans probably means they’ll be more volatile than high yield bonds. they currently are.

“You’ll notice that [the ETFs] do hold high yield bonds,” Laipply continued. “Part of the reason they hold them [is] they’re using them as a liquidity buffer in case they need to meet redemptions. You’ll probably see more volatility with a loan fund.

“It doesn’t show up right now [because the market is] sanguine,” Laipply concluded. “But if you do go back, [you'll see] the S&P 100 loan index behaved during the fall of 2008 with a pretty significant amount of volatility.”

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There are 4 comments

OCTOBER 4, 2013 8:33 A.M.

Frank Grimes wrote:

So these are decidely negative comments on a market that has been around for a long time. There are numerous shops that fully understand this market and have products available that absolutely had a performance dip during the '08-'10 period (newsflash: so did 98% of the financial world), which staid the course and have come back to show very good perfomance in the period since.

As with any asset class, you want to get involved with a manager who actually knows something about the assets, and can rationally explain to you what will happen to the market in a "super downside" scenario, such as a once-in-a-century recession such as the one the financial markets just went through. I'm not sure that either of the managers mentioned in this blog have that experience.

Another point--to say that there is a potential liquidity problem in the market right now is irresponsible, in my opinion. There is a very large market for 1st lien, higher quality loans--larger than these gentlemen might like to think....at this point it is no less liquid than the high yield asset class, which of course is subject to change. Touting liquidity of an investment as a risk borders on treating it unfairly, unless you have solid proof showing that there is not an active market for that class.

OCTOBER 5, 2013 10:42 A.M.

BondTrader wrote:

With the overwhelming consensus being that stocks are headed higher and higher doesn't it stand to reason that this would be due to an "improving" economy? In this case loan funds should continue to do well. If Vanguard is suggesting that loan funds are looking risky due to the potential of recession then shouldn't investors be getting out of stocks? Is Vanguard encouraging their investors to scale back on equity exposure? It would seem the message the stock market is sending, at least for now, is that things are looking better for the economy, therefore, loan funds should continue to due well. Am I missing something?

OCTOBER 6, 2013 9:33 A.M.

Dr. Strangelove wrote:

As usual, Vanguard is way behind the curve in developing new funds

NOVEMBER 19, 2013 10:51 P.M.

ED wrote:

Using Market Watch I found the following approximate maximum drops in the 2008-2009 decline::LQD -27%; JNK -47%; PFF -70%; DIA -33%; GLD -60% TLT +42%.These are exaggerated some because I took the lowest price on the lowest day. I believe I read someplace that the loan index dropped 30%. There were no loan ETF's then and a bubble might make the loan drop larger.

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As exchange-traded funds and other investing vehicles have ballooned in number, the task of figuring out what works well and what doesn’t has only gotten harder. Barrons.com’s Focus on Funds looks under the hood of ETFs, mutual funds and hedge funds for overlooked values, actionable ideas and the latest pitfalls for fund investors.

Chris Dieterich has covered the U.S. stock market for The Wall Street Journal and Dow Jones Newswires. He is a graduate of Regis University and the Missouri School of Journalism.